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Minsky breaks modern financial lending into three risk categories: hedge,

speculative and Ponzi finance. In order, this refers to the level of fragility from the safest to the most risky. In hedge finance, an individual or institution holds enough liquid cash to payoff the entirety of the obligation, including interest, at any time. This means the

borrower is able to “fulfill contractual payment commitments on liabilities” (Minsky 1992b 4). Speculative finance signifies that the incoming cash flows are enough to pay off interest but not the full value of the commitment. Lastly, a Ponzi posture means the individual or institution lack the ability to pay either interest or the principle value. In Ponzi finance, the borrower must borrow further in order to repay the initial commitment, placing

themselves in more debt. “Note that Ponzi financing decreases equity for debt increases without any increase in assets” (Minsky 1992b 6). If the institution does not borrow more money to cover the interest payments required, they will default on the obligation.

These different financial strategies determine the fragility of an institution. Each economy holds a mixture of hedge, speculative and Ponzi postures. If there is a majority of hedge finance, the institution is likely to be less fragile than one that is saturated with Ponzi positions. Banks use speculative finance, as they are able to replay interest to investors but do not hold enough liquid cash to repay the full amount. This system stays relatively stable as banks could maintain paying interest to their investors as long as they did not withdraw their initial sum. However, if banks were to use Ponzi finance, the system would be

extremely risky and unstable and inevitably lead to a crash. “A liability structure in which units are heavily in debt so that speculative and even Ponzi finance are common will be

towards the fragility end of spectrum” (Minsky 1992b 5). Each financialized institution balances on some combination of the three postures.

Financial fragility is the weakness behind a capitalist economy. Unlike an industrial based economy, financialization balances on speculative monetary exchanges. The

problem with this is that financial business uses few real foundations as supports.

According to Minsky, “a collapse of asset values, which forces the price of capital assets below the cost of production of investment output, could occur in many countries” (Minsky 1992b 2). Minsky sees this as the risks in a financial economy and he believes this collapse would undoubtedly lead to a global depression.

The early 1990s saw the development of securitization of financial institutions. One purpose of this was to move assets off balance sheets. Doing so would reduce capital requirements. “If assets did not need to be counted, leverage ratios could rise

tremendously” (Wray 2011a 5). The institution is also able to choose its risk and return using securities. This securitization system grew tremendously, as Minsky said, “that which can be securitized will be securitized” (Minsky 1987). Using securities, businesses avoid the traditional banking system.

Minsky uses the phrase, “make position by selling out position” (Minsky 1992c), in order to describe the strategy among financial institutions. This terminology refers to the position of banks and other institutions that use financial lending and borrowing. Selling position refers to selling debt in order to have more capital to invest. Banks and firms then lend this borrowed money to individuals in the form of loans. The institutions will then profit from the loans’ interest to pay back their debt. This type of business can range from

stable to fragile based on the above borrowing practices that are used. As we will see below, capitalist tendencies move lending and borrowing into a riskier state.

Keynes’ financial instability interpretation, or the financial instability hypothesis, believes that after a duration of economically strong time, a financial institution will progress toward fragility. The theory believes that as a capitalist institution develops, it will become progressively financialized. This means it would rely more and more on borrowed money and therefore moving further from hedge and closer toward Ponzi finance. This dependency is based on the exchange of present money for future money.

“The present money pays for resources that go into the production of investment output, whereas the future money is the ‘profits’ which will accrue to the capital asset owning firms” (Minsky 1992c 2). Firms understand that it will be more profitable to borrow more money and therefore hold less liquid capital.

During the 1990s and 2000s, banks and financial institutions were undergoing this transition. It was more profitable to borrow more money in order to loan out further capital. This meant moving closer and closer toward Ponzi finance. In addition, banks were borrowing money short term rather than long term. “If the Fed was willing to raise rates that much, no financial institution could afford to be stuck with long-term fixed-rate mortgages” (Wray 2011a 5). Short-term borrowing allowed them to have fewer costs associated with each sum of borrowed money. The problem with this system is it relies on the loans and interest coming into the bank to pay back the debt. If the institution does not have these cash flows it cannot repay its debts. As we will see below, this became a major problem leading up to the financial crisis.

Minsky understood the capitalist banking cycle and believes it is a natural progressive change. His theory is that capitalism drives toward financialization and institutions will therefore try to continuously “make position by selling out position”. As this occurs further and further, the economic structure will become more fragile. The riskier financial policies will create wholes that could collapse the system. This means a collapse and a resurrection are destined within this system. Minsky stated that

government intervention is natural part of the process and should not be viewed as a

“bailout”. He stated:

The need for the government to intervene to refinance savings and loan associations and commercial banks should be viewed as a normal and therefor expected result of the characteristics of the economy which make intermittent bouts of chaos,

incoherence or hysteresis occur and where the consequences of allowing free reign to such “states of nature’ are deemed unacceptable (Minsky 1992b 13).

This means Minsky understood the build up to and the reasons behind financial crises. He believed it was expected for the financial institutions to become increasingly fragile leading to a crash.